When, in September, Mario Draghi mentioned the euro exchange rate as one of the factors likely to influence the ECB’s monetary policy – alongside inflation and growth – few economists took him seriously. The euro’s rally since the spring, along with the obvious risk of a further rise if the ECB tightens monetary policy, meant that some caution was needed and made it acceptable to bend the previously established rule that the ECB bore no responsibility for the euro’s exchange rate. Seven weeks later, there no longer seemed to be any concern about this issue. Not only did eurozone economies, posting very good economic figures, appear to have coped with the euro’s rally, but the Fed had also clarified its strategy, reducing the risk of a further rise in the euro. As a result, the ECB was in theory able to relieve itself of the exchange-rate burden and make a more decisive commitment to bring its policy gradually back to normal.
Will the raft of measures announced by the ECB be enough to restore growth in the euro area? The answer will depend on the following three factors:
– The effective size of the package,
– The ability of demand for credit to be stimulated,
– The return of a more favorable international economic context, which provides an outlet for improved competitiveness that has been at the origin of deflationary risk.
The markets have been circumspect with regard to these measures because none of these factors are guaranteed to materialize at this point.
The current approach to managing the sovereign debt crisis is so absurd that it will wind up destroying the European Monetary Union—perhaps even faster than anyone dares to imagine today. With the economy in free-fall since mid-spring, pressing ahead with fiscal adjustment programs means exposing Europe’s crisis-ridden countries to major risks.
Spain’s creditors initially greeted the new austerity plan unveiled by the Rajoy administration with a sigh of relief. Immediately after the prime minister’s announcement, long-term interest rates fell by a substantial 20 bps to 6.60 percent. The pledges offered by the Spanish government in exchange for greater flexibility in meeting the deficit reduction targets set by Brussels seem to have convinced observers. What probably made the biggest impression were the promises to overhaul public administration, with the number of local government councilors to be cut by 30 percent, and at the same time to raise the value-added tax rate by three percentage points.
Yet there are serious grounds for concern about whether Spain can overcome the crisis in this way.
It all started out with high hopes. The idea was to build a united Europe that would enhance well-being all around. A sharing Europe that gave the continent’s least developed countries an opportunity for fast-track convergence with the wealthiest countries. And lastly, a peaceful Europe—because the combined economic strength and weight of its members would ensure lasting cohesion.
In the first several years, those hopes appeared to be more than well-founded. When Spain joined the EU in the mid-1980’s, the country’s living standards lagged 25 percent behind the French-German average. Within less than fifteen years, the ensuing boom had lifted Spanish per capita income by 50 percent, making up for nearly half of the initial differential. Over that time span, massive foreign investment drove industrial expansion and exports quadrupled in volume, with 75 percent going to other EU Member States. The labor force also increased from 11 million to 15 million, while year after year, EU structural transfers, of which Spain has long been the leading recipient, helped the country gradually build up infrastructure to the level required to secure long-term growth.
The outcome of the pro-cyclical policies imposed on the distressed countries in the Monetary Union was a foregone conclusion. Greece is bankrupt, Spain is teetering on the brink, the eurozone is going under, and the rest of the world is getting dragged down with it. The risk of another global recession is high, and a breakup of the common currency area has never seemed as likely. The chaos that such a combination would unleash is not only unfathomable; it is also so terrifying that no one can imagine just looking on in resignation. A sea change is urgently required.
The idea of trying to deleverage over-indebted countries through austerity policies that kill growth is sheer economic nonsense. That approach was predicted to fail, and now it has, as the situation in Greece and Spain makes excruciatingly clear. Nor is there any reason for the list of victims to stop there—it will keep getting longer unless the Europeans break swiftly with the policy they have been pursuing since the spring of 2010. It must be stressed over and over that by undermining growth, austerity automatically worsens the fiscal predicament of the States affected, and is driving the entire region into a crisis it may ultimately prove unable to overcome.
What should be done? There’s only one valid answer: a 180-degree turn away from the economic policy followed up until now.
This requires three simultaneous, urgent changes. 1) The unfolding recession must be short-circuited; 2) governments must be protected against rising borrowing costs; and 3) deficit reduction must be scheduled over longer periods to enable economies to catch their breath. Whatever the specifics, such a policy will necessarily involve unprecedented action by the ECB that boils down to monetization of sovereign debt to a greater or lesser extent. This is not an optional move, either. Assuming it isn’t too late already, it is the only way to put a stop to the destructive spiral in which the European countries have been trapped for over two years now—and which the Monetary Union has no chance of withstanding.
The danger would undoubtedly be less imminent if the global economy hadn’t taken such an abrupt turn for the worse in the last few months. Europe’s leading economic indicators reveal a particularly alarming picture today, bearing an uncanny resemblance to the one at the onset of the crisis in 2008. The latest data available point to a serious deepening of the recession in Italy and Spain. Household spending in both countries, which had previously held up fairly well, is poised for a sharp downward adjustment during the next few quarters. In Italy, retail trade has already slumped beneath the low reached in 2008. In Spain, where purchasing power has contracted by 4 percent over the past twelve months, the household confidence index strongly suggests there will be a similar decline in real consumer spending between now and year-end. Moreover, with the French economy showing flat growth—at best—and Germany feeling the after-effects of shrinking demand for its exports, the unfolding recession appears to be much deeper than anyone previously imagined. It will unquestionably lead to further fiscal deterioration in an increasing number of countries and an unavoidable worsening of the sovereign debt crisis, which is almost sure to balloon into a global systemic crisis. The key fact is that neither the United States nor China are growing fast enough to be in a position to absorb another shock from Europe. Time is running out. Unless there is a sharp, rapid break with previous economic policy, we should soon be bracing ourselves for the worst-case scenario.